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Did you know that in the United States, there’s a distinct difference between a real estate dealer and a real estate investor?
Whether you’re flipping houses, buying rental properties, or partnering on a development project, everyone who invests in real estate falls into one of these two buckets.
These are two separate tax classifications by the IRS. And whichever bucket you fall into, it can have a huge impact on how much you pay in taxes for each real estate deal you do.
But how are they different, and how does taxation come into play?
Real Estate Dealer vs. Real Estate Investor: What They Do
A real estate dealer regularly buys and sells real estate “in the ordinary course of their trade or business.”
What does this mean exactly? Well, some common examples of real estate dealers include:
- House flippers who buy houses fix them up and sell them for a higher price to make a profit.
- Real estate developers, who buy land, build subdivisions, and resell the lots.
- Real estate wholesalers who buy properties and resell them quickly without making any changes or improvements to the properties.
- Land investors, without any other sources of income, who buy land at a low price and resell it quickly for a higher price, with or without making any improvements or changes to the land.
- Any real estate transaction where the properties are treated like inventory that regularly cycles on and off the balance sheet.
By contrast, a real estate investor buys real estate with the intent of holding it as a long-term buy-and-hold investment. Some examples of a real estate investor include:
- An individual who buys a rental property.
- An entity that buys an apartment building and rents out the units to various tenants.
- A mobile home park owner who buys land and/or mobile homes and leases them out to the residents of the park.
- A storage facility owner who rents out individual storage units.
- Any property that is purchased to generate an ongoing source of rental income.
In other words, a real estate dealer buys and sells real estate for a profit, while an investor buys land and holds on to it to gain cash flow.
Why the Difference Matters: Taxes
The average person (especially one who doesn’t deal with real estate) won’t mind, but the IRS does—a lot. And the distinction between them matters because the tax that one pays is different from that of the other.
When you compare a real estate dealer to a real estate investor, a dealer is taxed like someone running a business that buys and sells inventory.
Meanwhile, an investor is taxed like a passive investor who collects long-term, regular income from their assets.
Here’s a more in-depth look at the rationale behind this taxation principle.
Real Estate Dealer
Because dealers treat their properties like inventory, they are subject to all the normal taxes that regular businesses must pay (like self-employment tax and short-term capital gains). This means a dealer will pay more taxes than an investor.
In addition, if a dealer sells a property through an installment sale, they will have to pay taxes on the entire proceeds from the sale immediately in the first year, not over time as the payments are collected.
There is one small exception for certain types of residential land sales. But for any other type of real estate installment sale, all those taxes must be paid immediately in that first year. This deters a lot of dealers who sell their properties with owner financing.
Real Estate Investor
On the other hand, an investor has a much more favorable tax position due to a few things.
- When they sell their properties, they pay a lower long-term capital gains tax because they hold on to them longer.
- They are not subject to the self-employment tax applied to real estate dealers.
- They pay taxes on their installment sale proceeds as the money comes in, not immediately in the first year.
Remember, real estate investors who own rental properties can write off depreciation, a huge tax advantage that real estate dealers don’t have. The reason is that a dealer’s properties are treated like inventory, not long-term, cash-flow-producing rental properties.
How Does the IRS Distinguish Between the Two?
Technically, the IRS doesn’t specifically define what a “real estate dealer” is. This means there are a number of different ways to describe a dealer, and the definition is ultimately open for interpretation by the prevailing court.
However, according to the IRS, the “correct answer” on whether a real estate transaction is made under a dealer or an investor status depends on a number of factors:
- Why the property was acquired.
- The original intent of the buyer.
- What kinds of improvements (if any) were made, and to what extent?
- The frequency and number of sales the investor has made.
- The amount of income generated by the property compared to the individual’s other sources of income.
- The nature of the taxpayer’s business.
- The extent of advertising that was done to promote sales of each property.
- Whether the property was sold directly or through brokers.
- How long the property was held before being resold.
Generally speaking, if you’re buying and selling real estate and you do it in large quantities in a given year, chances are, you will be classified as a dealer.
However, the IRS can and will have the final say on whether you’re a real estate investor or a dealer. If they disagree with your assessment, they have the authority to override you.
But this doesn’t mean the tax situation is all bad for real estate dealers. Dealers do have one tax advantage: Their gains are considered “ordinary,” which means they can use any losses to offset their gains.
The classification of a dealer and an investor can have big implications for the taxes a person has to pay. So you can probably imagine most people will do everything possible to avoid being classified as a dealer.
Is There Any Way You Can Change Your Status?
Interestingly, this classification often has more to do with a person’s intent than what actually ends up happening with each property.
For example, someone could buy a rental property with the intent of holding it long-term, but they end up selling it sooner for unforeseen reasons. Depending on the nature of the situation and the outcome of the criteria described above, they may still be considered an investor because of their original intent.
Likewise, there could be a developer who has technically held onto their properties for many years or for much longer than anticipated. But since their original intent was to sell their properties quickly, they would still be considered dealers in most cases, even though the properties unintentionally turned into a longer-term investment.
Note that one taxpayer can be both an investor and a dealer simultaneously. Under the IRS Code, each property is assessed independently. In other words, a real estate investor can have a portfolio of rental properties where they are considered an investor while being a dealer in another property they bought and subsequently flipped.
So, that “investor” or “dealer” label doesn’t necessarily have to apply to everything they own. The distinction is applied for each property, depending on their intent when they purchased it.
How Can You Prove Your Intent as an Investor?
Since your intent plays an important role in qualifying you as an investor rather than a dealer, what can you do to solidify your case for the IRS?
What boxes can you check to give yourself the strongest argument for being labeled an investor?
It helps to understand that a real estate investor tends to hold properties for capital appreciation and rental income, and their profits are typically considered capital gains, which often carry a lower tax rate. A dealer, however, is a person who buys and sells properties as part of their regular business, with their profits being treated as ordinary income and subject to self-employment tax.
If your goal is to prove that you're an investor rather than a dealer, consider these steps:
1. Long-Term Holdings: Investors typically hold properties for longer periods (over a year), while dealers sell properties quickly. By holding onto your property and renting it out for income, you can indicate that you bought it for investment purposes.
2. Purpose of Purchase: Document the reason for your purchase. If it's for capital appreciation or to generate rental income, you're probably an investor. If you're buying to sell quickly for a profit, you're behaving more like a dealer.
3. Number of Transactions: Investors generally do fewer transactions per year than dealers. If you're doing a high volume of transactions each year, it may appear you're running a trade or business, indicating you're a dealer and not an investor. You could potentially manage this perception by having a separate entity that exists for a smaller number of long-term investments or even a single entity formed solely for the purpose of owning one property (and it wouldn't hurt to name that entity something that supports the case for an investor, such as “ABC Long Term Investments, LLC”).
4. Nature and Purpose of the Acquisition: The manner in which you market and sell the property also affects the classification. If you immediately list the property for sale the day after you purchase it, this would add to the narrative that you're a dealer. However, holding the property for a year or over two calendar years would add to the narrative that you're an investor.
5. Development and Improvement: Excessive improvements can imply dealer status because it indicates an active effort to sell. Investors generally make improvements to increase the rental value. If you make any improvements to the property, ask yourself, “What improvements would allow me to increase my rent revenue from this property?”
6. Income: If a significant portion of your income comes from the rapid buying and selling of property, you might be considered a dealer. Investors typically earn income from rent and capital appreciation.
7. Separate Entities for Different Activities: If you are a real estate dealer AND an investor, you should keep these activities separate. Create separate legal entities for your dealer and investor activities and keep a clear separation between both entities.
8. Record Keeping: Properly document your intentions for the property at the time of purchase and maintain detailed records. This will help in case you have to defend your status as an investor. For example, you could email your CPA or broker a time-stamped email explaining that you intend to own the property as a long-term investment. Save this email and keep it in your records as evidence of your original intent behind the purchase.
9. Legal and Financial Counsel: A real estate attorney or accountant can provide advice and ensure that you follow the correct procedures to establish your intent as a real estate investor.
Remember that these are only suggestions. The IRS will consider the facts and circumstances surrounding each case. It's a good idea to consult with a tax attorney or a certified public accountant specializing in real estate taxation to get personalized advice.